Insider mosaics …

We’ve all heard of “insider trading” and we all have a general idea of what it means: securities laws prohibit trading on material, non-public information. The policy underlying the prohibition is that markets work best when they seem fair and can generally be trusted, in comparison to markets that seem rigged or unreliable. Effective capital markets are founded on trust.

At the same time, though, the free-market system assumes that the “correct price” is determined only once buyers and sellers possess “perfect information,” and that in turn depends on ferreting out facts that may not be obvious or generally known. In the parlance of Wall Street, the work of discovering not-so-obvious facts is the “mosaic theory.” Andrew Sorkin explains:

Every day, professional investors and research analysts work the phones to ferret out information about companies that can’t be found by simply reading news releases. Some will walk through shopping malls interviewing store managers at Gap, for example, to gauge how sales are going. Others might monitor sales of certain component parts in Asia to determine how many iPads Apple might sell this quarter. Investors use multiple tidbits of nonpublic information from various sources to build a “mosaic” to try to get an edge on other investors.

The difficulty is, the beneficial aspect of pursuing complete information — mosaics — sometimes crosses the line and becomes “insider trading.” And the S.E.C. may be taking action, at least according to a client alert from the law firm Fried Frank. Again, according to Sorkin:

Amid a wide-ranging investigation by the Securities and Exchange Commission and federal prosecutors into hedge funds and the “expert networks” that supplied them information, some investors may be asking themselves if their “mosaics” may soon be considered “insider trading. … “The S.E.C.’s recent enforcement docket reflects a belief that certain buy-side investors’ investment activities were rife with insider trading violations, and there are more to be found,” the law firm Fried Frank wrote in a note to its clients last week …”

The take away? Research publicly accessible information thoroughly. Investigate non-publicly available information carefully.

Update 12/01/2010: Today’s editorial in the New York Times carries a similar warning:

Prosecutors are warning that the crime of insider trading is becoming an all too common way of doing business. Preet Bharara, the United States attorney policing Wall Street, recently told the New York City Bar Association that “illegal insider trading is rampant” and vowed that he would use “every legitimate tool” to track down and prosecute this crime. It’s about time.